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An overview of California's 2003 tax shelter and abusive tax shelter legislation.

In the fall of 2003, the California Legislature passed, and Governor Gray Davis signed, Senate Bill 614 (1) and Assembly Bill 1601. (2) As characterized by the California Franchise Tax Board, "[n]ew California law authorizes the Franchise Tax Board to aggressively combat abusive tax shelters and transactions by adding substantial penalties, along with new registration and reporting requirements for both investors and promoters of abusive tax shelters." (3) This article summarizes the major provisions of the legislation, including the FTB's Voluntary Compliance Initiative, which is effective from January 1, 2004 through April 15, 2004. (4)

Background

On April 21, 2003, Senators Cedillo and Burton replaced the provisions of pending Senate Bill 614 with language intended to curtail the use of what the Legislature and the FTB perceived as abusive tax shelters. The bill proceeded through many iterations, with the most significant substantive dispute focusing on the proposed codification of the so-called economic substance doctrine. Largely as a result of public comments, (5) the bill was amended in September 2003 to remove the proposed codification of the economic substance doctrine. The California tax shelter legislation was originally based upon Senator Grassley's CARE Act of 2003 (S. 476), which passed the U.S. Senate 95-5 in March 2003. The CARE Act contained tax shelter provisions similar to the provisions of the California legislation. While S. 476 stalled in Congress, however, the California legislation proceeded. Indeed, Governor Davis emphasized in the Press Release surrounding his signing of Assembly Bill 1601 and Senate Bill 614 on October 2, 2003, that "[o]nce again, California is ahead of the pack. In fact, we are taking action before the federal government to curtail the use of abusive tax shelters." (6)

As will be seen below, the clear thrusts of the legislation are to create new penalties and registration requirements, and to stiffen existing penalties and registration requirements, as they relate to tax shelters and potentially abusive tax shelters. As also will be discussed below, a major component of the Legislature's "carrot and stick" approach under the legislation is the VCI, which will expire on April 15, 2004.

The Major Provisions of the Legislation

1. Disclosure of Certain Items on Tax Returns

California Revenue and Taxation Code (CRTC) [section] 18407 conforms to section 6011 of the Internal Revenue Code, thus requiring a taxpayer to disclose with its tax return certain information with respect to each "reportable transaction" in which the taxpayer participates. (7) The section defines "reportable transaction" to include any transaction of a type that the Secretary of the Treasury or the FTB "determines as having a potential for tax avoidance or evasion including deductions, basis, credits, entity classification, dividend elimination, or omission of income and shall be reported on the return or statement required to be made." (8) Under the Treasury regulations, there are currently six categories of reportable transactions. (9) The first such category is any transaction identified by Treasury as a tax avoidance transaction whose tax benefits are subject to disallowance under present law (referred to as a "listed transaction"). FTB has authority under the legislation to identify "reportable transactions" and "listed transactions" beyond those identified by the Treasury Department, for California income or franchise tax purposes. (10)

The FTB is directed by the legislation to publish "listed transactions," whether identified by the IRS or the FTB, on the FTB website, and in FTB notices or other published positions. (11) The FTB's first such publication is Chief Counsel Announcement 2003-1 (December 31, 2003). Briefly, it states that "California 'Listed Transactions' include all federal Listed Transactions," and it lists two "other" California Listed Transactions: (1) Certain Real Estate Investment Trust (REIT) Transactions and (2) Certain Regulated Investment Company (RIC) Transactions.

The effective date of this provision is complex. FTB states the provision is effective January 1, 2004. (12) Except for persons that invest in a tax shelter that becomes a listed transaction, this section applies to taxable years beginning on or after January 1, 2003. For the purpose of applying CRTC [section] 19778, relating to a higher interest rate for understatements of tax related to using a reportable transaction (which applies for taxable years beginning after December 31, 1998), the section applies for taxable years beginning after December 31, 1998.

2. Maintaining Tax Shelter Investor Lists

The legislation enacted CRTC [section] 18648, which conforms to the federal requirements of IRC [section] 6112, with modifications. This requires organizers, sellers, and material advisers of potentially abusive tax shelters to keep and provide lists of investors. Modifications include maintaining lists regarding potentially abusive tax shelters organized in California, doing business in California or deriving income from sources in California or where at least one of its investors is a California taxpayer. (13)

For transactions entered into on or after February 28, 2000, that become federal listed transactions at any time, the lists shall be provided to the FTB no later than the later of 60 days after entering into the transaction; 60 days after the transaction becomes a listed transaction, or April 30, 2004. (14) In addition, lists shall be provided to the FTB under the same time frame above for transactions that become California-only listed transactions entered into on or after September 2, 2003. (15)

The FTB states this provision is effective January 1, 2004. (16) Except for persons that are material advisers for tax shelters that become listed transactions, this section applies on or after January 1, 2004. For transactions entered into on or after February 28, 2000, that become federal listed transactions at any time, the registration required by the section cannot be due any earlier than April 30, 2004. The section does net apply to a licensed attorney for transactions entered into before January 1, 2004, if the attorney became a material adviser solely because of the practice of law.

3. Tax Shelter Registration

The legislation amends CRTC [section] 18628 to conform to the federal tax shelter registration requirements of IRC [section] 6111, with modifications. Modifications include the registration in California of a tax shelter organized in California, doing business in California or deriving income from sources in California or where at least one of its investors is a California taxpayer. (17) A transaction entered into on or after February 28, 2000, that becomes a federal listed transaction at any time must be registered by the later of 60 days after entering into the transaction, 60 days after the transaction becomes a listed transaction, or April 30, 2004. (18) Transactions that become California-only listed transactions at any time are required to register under the same time frames, if the transaction was entered into on or after September 2, 2003. (19) CRTC [section] 18628(b)(2)(A) allows the FTB to require information in addition to the information required for federal purposes. Pursuant to this authority, FTB has issued FTB Notice 2004-1 (January 30, 2004), which states that persons submitting information required by section 18628 shall also provide the applicable California business entity number. In the event the business entity is a corporation included in a group return for a combined reporting group, the California business entity number of the key corporation must also be provided.

FTB states the provision is generally effective January 1, 2004. (20) Except for persons that organize tax shelters that become listed transactions, this provision applies on or after January 1, 2004. For any transactions entered into on or after February 28, 2000, that become federal listed transactions at any rime, the registration required by the section cannot be due any earlier than April 30, 2004.

4. Reportable Transactions Understatement Penalty

The legislation creates a new reportable transactions understatement penalty under CRTC [section] 19773, which applies to listed or reportable transactions. This penalty is a significant addition to the California law, and is one of the most important provisions of the legislation.

For disclosed transactions, in general, a 20-percent accuracy-related penalty is imposed on any understatement attributable to an adequately disclosed listed transaction or reportable transaction. (21) The only exception to the penalty is if the taxpayer satisfies a heightened reasonable cause and good faith exception, which the FTB characterizes as the "strengthened reasonable cause" exception. For taxpayers contacted by the FTB, the strengthened reasonable cause exception is available only if (1) there was adequate disclosure of the relevant facts affecting the tax treatment of the item; (2) there is or was substantial authority for such treatment; and (3) the taxpayer "reasonably believed that the claimed tax treatment was more likely than net the proper treatment." (22) Moreover, reasonable belief must (1) only be based on the facts and law that exist at the time the tax return was filed; and (2) relate solely to the taxpayer's chances of success on the merits of that treatment and net take into account the possibility the return will net be audited, that the treatment will net be raised on audit, or that the treatment will be resolved through settlement if it is raised. (23)

There is nothing in the legislation to prevent a taxpayer from relying upon the opinion of a tax adviser in establishing reasonable belief with respect to the tax treatment of the item. (24) A taxpayer may net rely on the opinion of a tax adviser for this purpose, however, if the opinion is (1) provided by a disqualified tax adviser (25) or (2) is a disqualified opinion. (26)

If the taxpayer fails to adequately disclose the transaction, no reasonable cause exception applies, and that the taxpayer is subject to an increased penalty rate equal to 30 percent of the understatement. (27)

The FTB Chief Counsel may compromise all or any portion of the penalty. (28) The statute provides such "sole discretion" of the Chief Counsel may net be delegated, and that the determination may net be reviewed in any administration or judicial proceeding. (29)

The amount of the understatement under CRTC [section] 19773 is the sum of (1) the amount of the increase in taxable income that results from the difference between the taxpayer's treatment of the item and the proper treatment of the item, at the highest corporate or personal tax rate; and (2) the amount of any decrease in the aggregate amount of credits resulting from a difference between the taxpayer's treatment of an item and the proper tax treatment of such item. (30)

The amount of understatement attributable to the listed or reportable transaction is generally determined without regard to other items on the tax return. Except as provided in regulations, a taxpayer's treatment of an item shall net take into account any amendment or supplement to a return if the amendment or supplement is filed after the taxpayer is first contacted by either the FTB or the IRS. (31)

The CRTC [section] 19773 penalty does not apply to any understatement on which the noneconomic substance transaction understatement penalty is imposed under CRTC [section] 19774. (32)

CRTC [section] 19773 applies to taxable years beginning on or after January 1, 2003. (33)

5. Accuracy-related Penalty

The legislation also made changes to the 20-percent accuracy-related penalty in CRTC [section] 19164 with respect to potentially abusive tax shelters. For taxpayers contacted by the FTB regarding the use of a "potentially abusive tax shelter," the legislation modifies the definition of "substantial" for corporate taxpayers (other than S corporations). Under the legislation, a corporate taxpayer will have a "substantial underpayment" if the amount of the understatement for the taxable year exceeds the lesser of (1) 10 percent of the tax required to be shown on the return for the taxable year (or, if greater, $2,500); or (2) $5 million. (34) Prior law only contained the 10-percent threshold.

The legislation also raises the standard that a taxpayer must meet in order to reduce the amount of an understatement for undisclosed items. With respect to the treatment of an item whose facts are not adequately disclosed and the taxpayer has been contacted by the FTB, a resulting understatement is reduced only if the taxpayer had a "reasonable belief that the tax treatment was more likely than hot the proper treatment" (i.e., not whether there was substantial authority). (35)

The legislation also authorizes, but does not require, the FTB to publish a list of positions for which it believes there is no substantial authority or there is no reasonable belief that the tax treatment is more likely than hot the proper treatment. The list shall be published in FTB Notices or other published positions. In addition, "listed transactions" notices shall be published on the FTB's website. (36)

The CRTC [section] 19164 penalty is not imposed on any portion of the understatement relating to an item subject to the reportable transactions understatement penalty under CRTC [section] 19773, (37) or subject to the noneconomic substance transaction understatement penalty under CRTC [section] 19774. (38)

The legislative changes to the CRTC [section] 19164 accuracy-related penalty apply to penalties assessed on or after January 1, 2004. (39)

6. Tax Return Preparer Penalty

The legislation amended CRTC [section] 19166 to include a new requirement that there be a "reasonable belief that the tax treatment of the position was more likely than not the proper treatment" (instead of the phrase "realistic possibility of being sustained on its merits'). (40) The legislation also replaces the "not frivolous" standard with the requirement that there be "no reasonable basis for the tax treatment of the position." (41)

In addition, the legislation modestly increased the penalties from $250 to $1,000, and from $1,000 to $5,000. (42)

These provisions apply to penalties assessed on or after January 1, 2004. (43)

7. Failure to Register a Tax Shelter or Maintain a List Penalty

The legislation imposes a $15,000 penalty under CRTC [section] 19173 on any organizer who fails to register a shelter under CRTC [section] 18628 or to maintain and provide a list under CRTC [section] 18648. (44) If the penalty relates to a listed transaction, the amount of the penalty is increased to the greater of $100,000 or 50 percent of the gross income derived from the activity. (45) If there is intentional disregard by the organizer of the requirement to register, the penalty increases to 75 percent of the gross income. (46)

These penalties can be rescinded in whole or part by the FTB Chief Counsel, but only if (1) the transaction is not a listed transaction; (2) the organizer on whom the penalty is imposed has a history of complying with the state income tax laws; (3) it is shown that the violation is due to an unintentional mistake of fact; (4) imposing the penalty would be against equity and good conscience; and (5) rescinding the penalty would promote compliance with the tax laws and effective tax administration. (47) Such authority by the Chief Counsel cannot be delegated, and the legislation states an organizer may not review such a determination. (48)

These registration provisions apply to penalties assessed on or after January 1, 2004. (49)

8. Tax Shelter Promoter Penalty

The legislation amended CRTC 19177 to modify the penalty for promoting abusive tax shelters under IRC [section] 6700 to an amount equal to 50 percent of the gross income derived or to be derived by the person from the activity for which the penalty is imposed. (50) The new penalty rate applies to any activity involving a statement described in IRC [section] 6700(a)(2)(A) regarding the tax benefits of participating in a plan or arrangement. (51)

This provision applies to penalties assessed on or after January 1, 2004. (52)

9. Frivolous Return or Submission Penalty

The legislation modifies the frivolous return penalty in CRTC [section] 19179 for taxpayers contacted by the FTB regarding the use of a potentially abusive tax shelter by increasing the amount of the penalty ten-fold, to a maximum of $5,000 (from $500). (53)

The legislation also modifies present law with respect to certain submissions that raise positions identified by the FTB to be frivolous, or that are intended to delay or impede tax administration. The "submissions" to which this provision applies includes protests, protest hearings, installment agreements, and offers-in-compromise. The legislation permits the FTB to impose a penalty of $5,000 for such requests, unless the taxpayer, after notice, withdraws the submission within 30 days after being given notice. (54) The legislation requires the FTB to publish a list of positions determined to be frivolous for purposes of these provisions. (55)

This penalty can only be rescinded by the FTB Chief Counsel if (1) imposing the penalty would be against equity and good conscience; and (2) rescinding the penalty would promote compliance with the tax laws and effective tax administration. Again, the statute provides the Chief Counsel may not delegate this authority and that a taxpayer cannot have a refusal to rescind a penalty reviewed in any administrative or judicial proceeding. (56)

This provision applies to penalties assessed on or after January 1, 2004. (57)

10. Subpoenas

For taxpayers contacted by the FTB regarding the use of a potentially abusive tax shelter, the legislation expands the authority under CRTC [section] 19504 to sign a subpoena of the FTB to include the Executive Officer of the FTB or any designee. (58)

This provision applies on or after January 1, 2004. (58)

11. Tax Shelter Injunctions

The legislation amends CRTC [section] 19715 to provide that an injunction may be sought against any person from further engaging in specified conduct. (60) "Specified conduct" means any action or failure to take actions subject to penalty under CRTC [section] 19173, 19174, ]9177, or 19178. (61)

This provision applies on or after January 1, 2004. (62)

12. Extended Stature of Limitations

The legislation enacts CRTC [section] 19755, which extends the statute of limitations from four years to eight years for taxpayers who invest in an abusive tax avoidance transaction. (63)

This provision applies to any return filed on or after January 1, 2000. (64) Because of this application date, this provision may prove to be one of the most significant aspects of the legislation.

13. Failure to Disclose a Reportable Transaction Penalty

The legislation enacted CRTC [section] 19722, which creates a new penalty for certain persons who rail to include on any return or statement any required information with respect to a reportable transaction under CRTC [section] 18407. This new penalty applies without regard to whether the transaction ultimately results in an understatement of tax. This new penalty applies in addition to other penalties. (65) The penalty for failing to disclose a reportable transaction is $15,000. (66) The amount is increased to $30,000 if the failure relates to a listed transaction. (67) The penalty only applies to large entities and high net worth individuals. A "large entity" is any person (other than an individual) with gross receipts in excess of $10 million for either the year of the transaction or in the preceding year. (68) A "high net worth individual" is any individual whose net worth exceeds $2 million immediately before the transaction. (69)

The penalty cannot be waived with respect to a listed transaction. (70) As to reportable transactions, the penalty can be rescinded by the FTB Chief Counsel, but only if (1) the taxpayer on whom the penalty is imposed has a history of complying with the California income and franchise tax laws; (2) it is shown that the violation is due to an unintentional mistake of fact; (3) imposing the penalty would be against equity and good conscience; and (4) rescinding the penalty would promote compliance with the tax laws and effective tax administration. (71) As with other relevant portions of the legislation, the authority to rescind the CRTC [section] 19722 penalty can only be exercised by the FTB Chief Counsel and cannot be delegated, and the taxpayer cannot appeal a refusal to rescind a penalty. (72)

The effective date of CRTC [section] 19822 is complex. FTB states (73) that except as provided, the provision applies to taxable years beginning on or after January 1, 2003. The penalty also applies to any person that is required to disclose a reportable or listed transaction under CRTC [section] 18407 and the person invested in a transaction after February 28, 2000, and before January 1, 2004, where that transaction becomes a listed transaction at any time. In a letter filed in the Senate Daily Journal on September 11, 2003, however, the FTB explained that the intent of the Legislature was that no penalty be imposed for California-only tax shelter transactions entered into before September 2, 2003. (74)

14. Non-Economic Substance Transaction Penalty

The legislation enacted CRTC [section] 19774 which generally imposes a penalty for an understatement attributable to a transaction that lacks economic substance. This is clearly one of the most significant provisions of the legislation. Unlike the new CRTC [section] 19773 understatement penalty (which applies only to listed and reportable transactions), the non-economic substance transaction penalty under CRTC [section] 19774 applies to any transaction that lacks economic substance, as defined. The penalty is 40 percent, but is reduced to 20 percent if the taxpayer "adequately disclosed" on the return the "relevant facts affecting the tax treatment of the item." (75) For purposes of this penalty, "adequately disclosed" includes the disclosure of the tax shelter identification number (a present requirement under CRTC [section] 18628(c)) on the return. (76) No exceptions, such as reasonable cause, are available to this penalty--in other words, this is a strict liability penalty--though the FTB Chief Counsel may compromise all or any portion of the penalty in certain situations. (77) The statute provides such "sole discretion" of the Chief Counsel may not be delegated and, further, may not be reviewed in any administration or judicial proceeding." (78)

A "non-economic substance transaction" includes "the disallowance of any loss, deduction or credit, or addition to income attributable to a determination that the disallowance or addition is attributable to a transaction or arrangement that lacks economic substance including a transaction or arrangement in which an entity is disregarded as lacking economic substance. A transaction shall be treated as lacking economic substance if the taxpayer does not have a valid nontax California business purpose for entering into the transaction." (79) The authors of the legislation have stated this language is not intended to create a new test, and that the authors' intent is for FTB to rely upon "the common law economic substance doctrine." (80) This intent is confirmed by a recent article by Joseph Bankman, Professor of Law and Business at Stanford Law School, who assisted in the drafting of the legislation. (81)

For purposes of this provision, the calculation of an understatement is made in the same manner as in the separate provision relating to the reportable transaction understatement penalty in CRTC [section] 19773. (82) Thus, the amount of the understatement under this provision is the sum of--

(1) the amount of the increase in taxable income which results from the difference between the taxpayer's treatment of the item and the proper treatment of the item, at the highest corporate or personal tax rate; and

(2) the amount of any decrease in the aggregate amount of credits that results from a difference between the taxpayer's treatment of an item and the proper tax treatment of such item. (83)

Except as provided in regulations, the taxpayer's treatment of an item will not take into account any amendment or supplement to a return if the amendment or supplement is filed after the taxpayer is contacted by the IRS or the FTB. (84)

This provision applies to penalties assessed on or after January 1, 2004. (85)

15. 100 Percent of Accrued Interest Penalty

New CRTC [section] 19777 provides that taxpayers contacted by the FTB for any underpayment of tax due to a potentially abusive tax shelter, as defined, are liable for additional interest equal to 100 percent of the accrued interest on the underpayment, from the due date of the return (determined without regard to extensions) to the date of the mailing of the FTB notice of proposed assessment. (86) A "potentially abusive tax shelter" is defined as any tax shelter with respect to which registration is required under IRC [section] 6111, or any entity, investment plan or arrangement, or other plan or arrangement of a type that the IRS or the FTB determines by regulations as having a "potential for tax avoidance or evasion." (87)

This increased interest penalty applies to notices of proposed assessment mailed after January 1, 2004. (88) It is in addition to any penalty or other interest that may be assessed. (89)

16. 50-Percent Increase in Interest Rate

The legislation enacted CRTC [section] 19778, which provides that for taxpayers not contacted by the IRS or the FTB regarding the use of a potentially abusive tax shelter, the prescribed interest rate is increased to a rate of 150 percent (i.e., a 50-percent increase) for an understatement of tax related to using reportable transactions as defined in CRTC [section] 18407. (90)

The higher interest rate applies to any amended return filed after April 15, 2004, and for taxable years beginning after December 31, 1998. (91)

17. Exception to Confidentiality Provisions

The legislation amended CRTC [section] 21028 to provide that no privilege applies to communications between a federally authorized tax practitioner and any person in connection with the promotion or participation of the person in any tax shelter. (92)

This provision applies to communications made on or after of January 1, 2004. (93)

The Voluntary Compliance Initiative

The Legislation also enacted CRTC [section] 19751, which required FTB to develop and administer a Voluntary Compliance Initiative (VCI). Taxpayers that utilized abusive tax shelters to underreport their tax liabilities may amend their tax returns and, in FTB's words, "come clean" (94) with California under the provisions of the VCI. The VCI is offered to taxpayers between January 1, 2004, and April 15, 2004. The VCI applies only to tax years beginning before January 1, 2003. (95)

CRTC [section] 19752 provides an eligible taxpayer with two elective options under the VCI. "Option 1" is voluntary compliance without appeal rights. This option generally includes the waiver of all penalties, including all existing and all new or increased penalties under the legislation. (96) This option provides that if the taxpayer's amended return is accepted by the FTB, the issue would be considered closed. The taxpayer cannot file a claim for refund and the FTB cannot issue any deficiency assessment relating to the item in question. (97)

"Option 2" is voluntary compliance with appeal rights. This option includes the waiver of all existing, and all new or increased penalties under the legislation, except the accuracy-related penalty under CRTC [section] 19164 as in effect prior to the passage of the legislation. (98) This option provides that if the taxpayer's amended return is accepted by the FTB, the taxpayer may file a claim for refund for the tax and interest paid under the VCI. (99) Notwithstanding the six-month "deemed dental" claim for refund provisions found in existing law, this VCI option provides a taxpayer may not file an appeal to the California State Board of Equalization until the FTB takes action on the claim for refund, or until the later of (1) 180 days after a final federal determination of the transaction, or (2) four years after the claim was filed, or one year after full payment of all tax, including penalty and interest was made. (100)

Under either VCI option, the taxpayer under CRTC [section] 17954 must file an amended return reporting all income and loss "without regard to the abusive tax shelter avoidance transaction." (101) The taxpayer may request to pay the tax and interest under an installment agreement. (102)

A taxpayer's election under the VCI shall be for all taxable years covered by the VCI, and a separate election for each such taxable year is not allowed. (103) Thus, if a taxpayer participates in the VCI for more than one year, it must elect the same option for each year.

Closing agreements may be used, but are not required. (104)

FTB is directed to issue the necessary forms and instructions, and some have already been issued as of the date of this article. For example, a "Voluntary Compliance Participation Agreement Form" for business entities, FTB 621, with instructions, was issued in November 2003, and is available on the FTB website. (105)

The VCI is not available under CRTC [section] 19753 to tax payers who are subject to a criminal investigation or have a criminal complaint filed against them. (106)

The VCI generally extends to any type of "abusive tax avoidance transactions" as defined, including but not limited to listed transactions under CRTC [section] 18407. (107)

Conclusion

It is far too early to attempt to assess the full ramifications of the legislation. However, some preliminary observations are in order. First, FTB certainly appears to have taken significant steps, in a single legislative session, to discourage under California law the promotion of and the participation in abusive tax shelters. Indeed, California law currently surpasses federal law on many such points.

Second, a case can be made that the current legislation comes at an unnecessary price of a lack of clarity, consistency, and in some instances, coherency, as a result of creating so much new law in so short a time. Much of what FTB once intended by this legislation was to recapture revenue being lost to California by California taxpayers' use of tax shelters as the federal level. The legislation, however, clearly moved far beyond that goal, and now includes many "California only" provisions specifically intended to neutralize (or at least minimize) the use of abusive tax shelters crafted for use at the California state income and franchise tax level. At times, the legislation is mind boggling in its creation of California only definitions, its selective and modified incorporation of provisions of the Internal Revenue Code, and its complex effective dates for the myriad of new rules.

Third, there are a number of obvious "hot spots" in the legislation that bear particular attention. Among them are the different effective dates for different provisions, the new reportable transactions understatement penalty under CRTC [section] 19773, the eight-year extended statute of limitations under CRTC [section] 19755 for abusive tax shelter transactions, the non-economic substance transaction penalty under CRTC [section] 19774, and the statute's providing that the FTB Chief Counsel's decision not to rescind certain penalties is nonreviewable.

The legislation does hot require any reports by the FTB to the Legislature, but it does require the FTB to provide information to the Legislative Analyst, who is required to provide the Legislature within two years a report regarding the effect of the legislation on tax shelters, state tax collections, and the state's business climate. (108)

Finally, a word of caution is in order. As with any complex new piece of tax legislation, one should expect problems of interpretation and implementation. While this article summarizes the major provisions of the legislation, it is no substitute for a careful and critical reading of the language of the new statutes themselves, and the Senate and Assembly histories of the legislation, and FTB's written statements regarding its interpretation and implementation of the legislation.

(1) 2003 Cal. Stat. ch. 656.

(2) 2003 Cal. Stat. ch. 654.

(3) December 3, 2003 Letter from FTB, mailed to approximately 7,000 taxpayers to bring attention to the FTB's Voluntary Compliance Initiative which was enacted as part of the legislation.

(4) Assembly Bill 1601 is identical to Senate Bill 614, and Senate Bill 614 was chaptered after Assembly Bill 1601. Accordingly, the legislative changes are discussed in the context of Senate Bill 614.

(5) See, e.g.,, Comments of Tax Executives Institute (August 29, 2003), filed with the California Senate's and Assembly's Committee on Appropriations, reprinted in 55 The Tax Executive 388 (September-October 2003).

(6) Office of the Governor, Press Release, "Governor Davis Signs Landmark Corporation Accountability Legislation (October 2, 2003)."

(7) All statutory references are to the California Revenue and Taxation Code (CRTC), except where otherwise indicated.

(8) CRTC [section] 18407(a)(3).

(9) The six categories are summarized in FTB Legislative Change No. 03-25, SB 614 (November 17, 2003), at 1.

(10) CRTC [sub section] 18407(a)(3) and (a)(4).

(11) CRTC [section] 18407(a)(4)(A).

(12) FTB Legislative Change No. 03-25, SB 614, dated 11/17/03, p. 3.

(13) CRTC [section] 18648(c).

(14) CRTC [section] 18648(d)(3).

(15) CRTC [section] 18648(d)(4).

(16) FTB Legislative Change No. 03-25, SB 614 (November 17, 2003), at 4.

(17) CRTC [section] 18628(g).

(18) CRTC [section] 18628(h).

(19) CRTC [section] 18628(i).

(20) FTB Legislative Change No. 03-25, SB 614 (November 17, 2003), at 4.

(21) CRTC [section] 19773(b).

(22) CRTC [section] 19164(d)(2).

(23) CRTC [section] 19164(d)(3).

(24) CRTC [section] 19164(d)(2).

(25) A disqualified tax adviser is an adviser who meets any of the following conditions: (1) is a "material advisor," as defined, and who participated in the organization, management, promotion or sale of the transaction or is related (within the meaning of IRC [section] 267(b) or 707(b)(1)) to any person who so participates; (2) is compensated directly or indirectly by a material adviser with respect to the transaction; (3) bas a fee arrangement with respect to the transaction that is contingent on all or part of the intended tax benefits from the transaction being sustained; or (4) as determined under regulations prescribed by the Secretary of the Treasury or the FTB, has a continuing financial interest with respect to the transaction. (CRTC [section] 19164(d)(3).) In general, a "material advisor" means any person meeting the requirements of CRTC [section] 18648. (CRTC [section] 19164(d)(3).)

(26) An opinion may not be relied upon if it (1) is based on "unreasonable" factual or legal assumptions (including assumptions as to future events); (2) "unreasonably" relies upon representations, statements, findings, or agreements of the taxpayer or any other person; (3) does hot identify and consider "all relevant facts"; or (4) fails to meet any other requirement prescribed by the Secretary of the Treasury or the FTB. (CRTC [section] 19164(d)(3).)

(27) CRTC [section] 19773(c).

(28) CRTC [section] 19773(c)(2).

(29) CRTC [section] 19773(c)(2).

(30) CRTC [section] 19773(b).

(31) CRTC [section] 19773(e).

(32) CRTC [section] 19773(e)(2)(B).

(33) Senate Bill 614, [section] 15 (2003 Cal. Stat. ch. 656).

(34) CRTC [section] 19164(a)(3).

(35) CRTC [section] 19164(a)(5).

(36) CRTC [section] 19164(b).

(37) CRTC [section] 19773(e)(1)(B).

(38) CRTC 8 19774(c)(I).

(39) Senate Bill 614, 9 15 (2003 Cal. Stat. ch. 656).

(40) CRTC [section] 19166(a)(2).

(41) CRTC [section] 19166(a)(3).

(42) CRTC [section] 19166(a)(i) and (b).

(43) Senate Bill 614, [section] 15 (2003 Cal. Star. ch. 656).

(44) CRTC 9 19173(a) and (b).

(45) CRTC [section] 19173(b).

(46) CRTC [section] 19173(b).

(47) CRTC [section] 19173(d).

(48) CRTC [section] 19173(d).

(49) Senate Bill 614, [section] 15 (2003 Cal. Stat. ch. 656).

(50) CRTC [section] 19177(b).

(51) CRTC [section] 19177(b).

(52) Senate Bill 614, [section] 15 (2003 Cal. Star. ch. 656).

(53) CRTC [section] 19179(b).

(54) CRTC [section] 19179(d).

(55) CRTC [section] 19179(c)(i).

(56) CRTC [section] 19179(e).

(57) Senate Bill 614, [section] 15 (2003 Cal. Star. ch. 656).

(58) CRTC [section] 19504(c)(2).

(59) Senate Bill 614, [section] 15 (2003 Ca]. Star. ch. 656).

(60) CRTC [section] 19715(a).

(61) CRTC [section] 19715(c).

(62) Senate Bill 614, [section] 15 (2003 Cal. Star. ch. 656).

(63) CRTC [section] 19755(a).

(64) CRTC [section] 19755(b).

(65) CRTC [section] 19772(g).

(66) CRTC [section] 19772(b)(1).

(67) CRTC [section] 19772(b)(2).

(68) CRTC [section] 19772(c)(2).

(69) CRTC [section] 19774(c)(1).

(70) CRTC [section] 19772(e)(1)(A).

(71) CRTC [section] 19772(c)(1).

(72) CRTC [sub section] 19772(e)(2) and (e)(3).

(73) See FTB Legislative Change No. 03-25, SB 614 (November 17, 2003), at 11.

(74) "It is our intent that the authority granted to the Franchise Tax Board by AB 1601 and SB 614 to identify and publish for California income or franchise tax purposes 'listed transactions' (as defined under subdivision (a) of Section 18407 of the Revenue and Taxation Code) does not apply to transactions occurring prior to September 2, 2003." September 11, 2003, letter to Senate President pro Tempore John Burton and Assembly Speaker Herb Wesson, from Gilbert Cedillo and Daria Frommer, reprinted in Senate Journal (Sept. 11, 2003).

(75) CRTC [section] 19774(b)(1).

(76) CRTC [section] 19774(b)(2).

(77) CRTC [section] 19774(d)(1).

(78) CRTC [sub section] 19774(d)(2) and (d)(3).

(79) CRTC [section] 19774(c)(2).

(80) The bills have been amended to limit the applicability of the penalty for 'noneconomic substance' transactions. It is our intent that the Franchise Tax Board rely upon the common law economic substance doctrine and that the penalty language contained in this section shall net be adopted by a court as a substantive definition other than for purposes of the penalty." September 11, 2003 letter to Senate President pro Tempore John Burton and Assembly Speaker Herb Wesson, from Gilbert Cedillo and Dario Frommer, reprinted in Senate Journal, Sept. 11, 2003.

(81) Bankman & Simmons, "Terminating Tax Shelters: Has California Broken the Legislative Logjam?," Tax Notes (December 1, 2003) at 1111 ("The section 19774 penalty was drafted so as to not establish any new substantive law.")

(82) CRTC [section] 19774(c)(1).

(83) CRTC [section] 19773(b).

(84) CRTC [section] 19773(e).

(85) Senate Bill 614, [section] 15 (2003 Cal. Stat. ch. 656).

(86) CRTC [section] 19777(a).

(87) CRTC [section] 19777(b).

(88) CRTC [section] 19777(d).

(89) CRTC [section] 19777(c).

(90) CRTC [section] 19778.

(91) CRTC [section] 19778.

(92) CRTC [section] 21038(b).

(93) CRTC [section] 21028(c).

(94) See FTB Legislative Change No. 03-25, SB 614 (November 11, 2003), at 10.

(95) CRTC [section] 19751(b).

(96) CRTC 8 19752(a).

(97) CRTC 8 19752(a).

(98) CRTC 9 19752(b).

(99) CRTC 9 19752(b)(4).

(100) CRTC [section] 19752(b)(4). This limitation on the right to appeal relates only to a taxpayer's "appeal" of the denial or deemed denial of the claim for refund to the California State Board of Equalization. It does not limit a taxpayer's right to file a suit for refund in a California court from the denial or deemed denial of a claim for refund.

(101) CRTC [section] 19754(a)(1).

(102) CRTC [section] 19754(b).

(103) CRTC [section] 19752(c).

(104) CRTC [section] 19751(c).

(105) www.ftb.ca.gov

(106) CRTC [section] 19753(a).

(107) CRTC 8 19753(c).

(108) Senate Bill 614, [section] 16 (2003 Cal. Star. ch. 656).

ERIC J. COFFILL is a partner in the Sacramento office of Morrison & Foerster LLP, where he practices with the State and Local Tax Practice Group. He is a regular contributor to The Tax Executive. Most recently, his article entitled "California's Water's-Edge Taxation of International Businesses: 2003 Update" appeared in the September-October 2003 issue.
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